Transfer pricing of trading goods
This guidance will be updated.
In the trading of goods, a company belonging to a group usually buys products from another group company and sells them further to third parties. Transfer pricing of trading goods must be at arm's length. The most pivotal objective of transfer pricing of sales operations is to ensure that both the sales company and the manufacturing company within the same group are able to accumulate the profits that independent enterprises would accumulate in a similar situation.
In transfer pricing of trading goods consideration must be given to the functions, assets and risks of the parties to the transactions
When the parties negotiate the sales prices and other contractual terms and conditions, it is essential to determine the sales-related functions performed and the risks assumed buy the sales company. The functions performed and the risks assumed by an independent enterprise have an impact on how the company is expected to perform financially. The impact of the functions performed and risks assumed on the profit levels of the sales company may naturally vary depending on the sector and the markets.
In addition to the sales and marketing functions, the sales operations also typically comprise functions related to sourcing, transportation and warehousing the goods, as well as financial management functions. Risks related to pricing, determination of the product portfolio, inventory management and accounts receivable are common risks related to sales operations. When assessing the transfer pricing from the perspective of the sales company it may be necessary to consider the assets used in the business operations. Such assets may include for example exceptionally large investments in fixed assets and intangibles related to the operations, such as sales licences and trademarks.
In transfer pricing, the operations of the sales company are often categorised in accordance with different operating models. These models can be for example an agent, a commission agent and a full-risk sales company. However, in transfer pricing analysis it is more relevant to precisely determine the functions performed by the company, as well as the actual risks and assets related to them.
Determining the arm's length price in trading goods
In order to determine the arm's length price, one of the parties to the transaction must be selected as a tested party. In practice the transfer pricing of intercompany trading of goods is usually assessed from the perspective of the sales company. A typical reason for examining the situation from the perspective of the sales company is that the sales functions rarely involve factors that are difficult to valuate (such as patents) which make the prices paid to the manufacturer more problematic to assess. If the terms and conditions applied and the price paid can be stated to correspond to that which would have been agreed on between independent enterprises, the terms and conditions are at arm’s length from the perspective of the group's manufacturing company as well. There are number of different methods for verifying that transfer pricing is at arm's length. The different methods are described in the transfer pricing guidelines of the OECD. The OECD guidelines are internationally accepted and an important source of interpretation when the arm's length principle is applied.
As a rule, the arm's length pricing of the intra-group trading of goods is indicated by means of comparable prices. Comparable prices are prices that are applied in trading of goods between independent enterprises. This method is called the comparable uncontrolled price method (CUP). The CUP method is the most suitable method when a company purchases similar products from third parties or sells the same products to independent enterprises and group companies.
It is rarely possible to indicate a comparable price used between independent enterprises. It is also practically impossible to obtain product prices from public databases. In such case, the arm's length nature of transfer pricing can be indicated, for example, by comparing the sales margins of the tested company and a comparable independent company. This method is called the resale price method (RPM). However, sales margins are rarely comparable due to the differing accounting practices between companies. Therefore the comparison is usually made between the operating profit levels. This method is called the transactional net margin method (TNMM). Comparison made at operating profit level is a well-established international practice.
Operating profit levels of independent enterprises can be examined using commercial databases (such as the Amadeus database of Bureau van Dijk). When searching for comparables in the database, it is important to use refined search criteria so that the companies displayed are comparable in terms of their functions, risks and for example use of valuable intangibles. The comparability of the individual comparables must also be carefully assessed in relation to the tested party.
Other matters to be considered in transfer pricing of trading goods
Careful consideration should be given to the following in transfer pricing of trading goods:
Added value generated by intangibles
The functions of the sales company may include active marketing activities regarding the brand. Even if the sales company would not own any intangibles, its marketing activities may have a significant impact on the brand value. These situations should also be identified and considered in transfer pricing. Utilization of unique intangibles in the operations may lead to a situation where the company cannot be selected as a tested party since no comparable transactions between independent enterprises can be indicated or there are no comparable independent enterprises.
Like independent companies, sales companies can sustain recurring losses in certain circumstances. The recurring losses may arise from the business strategy as the group is expanding to new markets. In such situation, the profitability of the new company may be weak at an early stage or the company may even be loss-making. This may derive from costs being too high in relation to the operating volumes, low margins resulting from the efforts to acquire/increase market shares or inefficiency in the operations. In such situations, it should be assessed whether an independent enterprise would be willing to continue operations on the same terms and for how long.
Respectively the sales company may continue its loss-making operations if the operations benefit the group in general. In such situation, an independent enterprise would continue its operations only if it was remunerated with a proper compensation for the benefits that it is generating and the functions that it is performing.
Changes in the group's operating model
When the group changes its operating model, some of the functions and risks of the sales company may be transferred to another group company. For the sales company, the change may mean a transfer from functioning in a distribution model to functioning in an agent model. Transfer of the functions and risks of the sales company will mean changes in its profit expectations, which should be considered in the company's transfer pricing model. As the functions and risks of the sales company change, it must be assessed whether the sales company should receive a separate compensation for the transferred functions.